Sins of the Father: The Effect of a Parent Firm's Accounting Misconduct on Current and Former Subsidiaries

We exploit a unique setting to examine how managerial and economic connections affect the current and former subsidiaries (“subsidiaries”) of a parent firm undergoing a restatement and bankruptcy. The demise of Enron and the varying nature of ties between Enron and its four publicly traded subsidiaries allow us to examine if capital market reactions for each of the subsidiaries surrounding Enron’s failure vary with the nature of their connections to Enron. We observe no significant differences in contemporaneous market reaction regardless of the nature and strength of connections between Enron and the subsidiaries, providing two main insights. First, over the year following the Enron events, those subsidiaries with ownership or accounting ties but with weak economic ties performed in-line with the industry, consistent with the lack of a differential market reaction across these sets of firms. This result contrasts with recent studies finding evidence of manager fixed effects affecting accounting choices. Second, we find that Enron’s most economically connected subsidiary (predictably) went bankrupt shortly after Enron, suggesting a market under-reaction at the time of the Enron events. Additional analysis provides some limited evidence that low institutional ownership or slow analyst forecast updating partly explains this under-reaction. Our study adds to the literature on restatements, management reputation effects, peer information transfer, and the market’s ability to react to specific fundamental information.